Should I Buy Severn Trent?

Published in Company Comment on 10 December 2012

Harvey Jones sizes up Severn Trent (LSE: SVT).

It's time to go shopping for shares again, but where to start? There are loads of great stocks to choose from, and I've got my wallet out. So here's the question I'm asking right now. Should I buy Severn Trent (LSE: SVT)?

Weak as water

It's been a soggy six months for water company Severn Trent, whose share price has plunged nearly 14% since June to £15.50. It is supposed to be a solid high-yielding utility, an ideal safe haven in these troubled times. So what went wrong, and is now the time to fill your glass?

Lucky number Severn

You might think a water company would welcome a wet summer (unlike the rest of us), but business customers such as farmers don't need to pay for stuff that is freely falling from the sky, and consumption fell 2.8%. This was more than offset by regulated price increases, which rose 5.2%, leaving overall group revenue up 3.5% to £917 million, according to the company's recent half-year results. Underlying profit before tax rose 1.6% to £157.5 million, and management raised its half-year dividend 8.2%, from 28.04p to 30.34p per share. Group debt rose slightly, as did customer bad debts, but Severn Trent said it was on course to meet its full-year earnings. Nothing too stormy, but the results still dampened market spirits. As did fading speculation of a takeover.

The Trent is your friend

Anybody who invests in UK utility companies has to worry about heavy-handed regulation. That's what persuaded dividend maestro Neil Woodford to sell his entire stake in both Severn Trent and United Utilities in 2010, warning that if pressed too hard, water companies will have to turn off the dividend taps. Investors are waiting to hear what Ofwat has in store for the next regulatory period (the current one ends in 2015), and that could cast further shadows over the sector. Efficiency targets are likely to remain tough, although Severn Trent's board says its £150 million investment programme is paying off, cutting leakages and pollution, and improving the service it offers to customers. But that's £150 million it won't be able to dish out to shareholders.

Sixes and Severns

The prime reason to invest in Severn Trent is its 4.5% yield, covered 1.3 times, which management aims to increase by 3% above inflation between now and 2015. But it is hampered by high levels of net debt at £4.05 billion, and will always be at the mercy of the regulator, who has to keep a restive public and meddling politicians happy. It also has only limited scope to expand its customer base. Long-term income seekers will be tempted, but with Severn Trent trading on a price-to-earnings ratio of 17 times earnings, they could end up overpaying for that yield. I'm not buying now. It would take a share price shock to change my mind. There's always the chance that an ill wind from the regulator could blow an opportunity our way.

Stronger stuff

Neil Woodford sold out of water companies because he could see better ways of tapping into a generous yield. If you want to know where he has found it, then download our free, in-depth report, "Eight Top Blue Chips Held By Britain's Super Investor".

This report by Motley Fool analysts is completely free and shows where Neil Woodford, the UK's top dividend investor, believes the best high-yield stocks are to be found today. Availability of this report is strictly limited, so click here.

> Harvey doesn't own any shares mentioned in this article.

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Comments

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F958B 10 Dec 2012 , 10:30am

I think the main reason for SVT's share price drop is fading hopes of a takeover.
SVT's earlier actions (putting their finanace in a precarious situation by paying a huge special dividend) suggested that they didn't want to be taken over.

At 17x forward earnings, with a 4.9% forward yield only covered 1.2x, and with extremely weak finances (maybe a rights issue in a year or two?) and risk of harsh regulation, I think that investors are likely to see better long-term returns if they look elsewhere.

The gas & electricity utilities are about fairly priced which looks considerably better value than expensive water utilities, while other reliable-dividned-paying defensive sectors such as food retailers and pharmaceuticals also look much better value long-term bets.

In these other defensive sectors, the yield is as good as the water sector, but with much better dividend cover, stronger finances, and much more money available to invest for growth, or much more money available to pay-down debt, or acquire other companies or carry out share buybacks..

I don't actually recall water companies ever trading at such high P/E ratios or such low yields as in the last year. Perhaps a mini-bubble?

If the valuations of water companies reverted back to the kind of levels of the 1990's, their share prices would be cut in half; taking a decade for dividends to compensate investors for the drop.

goodlifer 10 Dec 2012 , 10:41pm

"That's what persuaded ... Neil Woodford to sell his entire stake in... Severn Trent ...in 2010, warning that if pressed too hard, water companies will have to turn off the dividend taps"

IMO His Holiness is too easily frightened.
Ofwat would doubtless love to apply more pressure, but hasn't really got the guts.

My crystal ball forecasts that what with things like climate change, hosepipe bans and increasing demand, profits are likely to go steadily up.

Having said that, my c/b's so hopelessly unreliable I try to ignore it when I'm buying and just concentrate on value and yield.

If the PER were to fall to about 11 or less I'd seriously consider buying.
Till then, no thanks.

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